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Corruption in Small Business Fixed Investments: The Case of Indian Manufacturers

December 6, 2007, Maddalena Honorati and Taye Mengistae

The degree to which key business environment variables—such as labor regulations and power shortages—influence fixed investments by small and medium-sized enterprises (SMEs) depends on the incidence of corruption. In a sample of SMEs from the World Bank Enterprise Survey of India, the investment rate is found to be lower with more stringent labor regulation, more difficult access to external finance, or more severe power shortages—which is not particularly surprising. However, these effects are more pronounced when managers are concerned about corruption in making business decisions than when they are not.

What makes corruption bad for long-term economic growth? One answer from recent research is that corruption is a good proxy for weakness in property-rights institutions, which have a more abiding influence on economic performance than contracting institutions.[1,2]

When property rights are less secure there is a greater risk to citizens of expropriation by government and the politically powerful [1], and businesses and households are less likely to invest in durable and tangible assets. This in turn shows up as a negative correlation between the incidence of corruption and the rate of fixed investments.

Investment and growth could also be held back by poor or absent contracting institutions. But economic agents often get around problems with rules and regulations governing contracts (employment, supplier, or credit), albeit at a cost.

A new working paper by Honorati and Mengistae[3] looks at the importance of corruption and contracting institutions to business investment decisions using data from the World Bank Enterprise Survey for India and the corruption variable of Acemoglu-Johnson [1].

This study finds that the incidence of corruption influences the investment effect of contracting institutions

Specifically, the effects of labor regulation, power shortages, and access to finance on the rate of fixed investment all depend on whether or not the manager is concerned about corruption in making business decisions.

Over the full sample of enterprises, the rate of fixed investment is lower where power shortages are more severe and where labor regulation is stronger. Moreover, each of these impacts is greater for businesses self-reportedly affected by corruption.

While access to finance does not seem to influence the rate of investment for most firms, evidence suggests that investment decisions are constrained by cash flow only in enterprises unaffected by corruption or by power shortages.

The table shows the coefficient of indicators for the three “contracting institutions” in regressions of the rate of investment and the rate of fixed assets growth for two groups of enterprises—those that are self-reportedly constrained by corruption and those that are not. The term “constrained by corruption” indicates a dichotomous variable equal to one, if the manager of the business considers corruption a moderate to severe obstacle to growth, and zero otherwise.

The effects both of labor regulation and of power shortages increase with the incidence of corruption

The first two columns show that the investment rate is significantly lower where labor regulation is more stringent and where power shortages are more severe, which would not surprise those familiar with India’s industrial scene.

Labor regulation reduces the rate of investment by a greater amount in enterprises constrained by corruption than it does for those unaffected by corruption. Likewise, corruption seems to reinforce the effect of power shortages.

An increase in power shortages would reduce the rate of investment more among businesses self-reportedly constrained by corruption than it does among those unconcerned by corruption.

The financial constraint on investment is stronger for enterprises unconstrained by corruption

These conclusions are broadly confirmed by the last two columns, which present evidence that investment is subject to financial constraints to the extent that the rate of investment is correlated positively with cash flow but negatively with indebtedness.

Notes1. Acemoglu, D., and S. Johnson. 2005. “Unbundling Institutions.” Journal of Political Economy 113 (5): 949-95.2. Fernandes and Kraay (2006) test for the effect of corruption on per capita income in South Asian aggregate data. Their finding corroborates the Acemoglu-Johnson hypothesis. Fernandes, A., and A. Kraay. 2007. “Property Rights Institutions, Contracting Institutions, and Growth in South Asia: Macro and Micro Evidence.” In South Asia: Growth and Regional Integration. Washington DC: World Bank.3. Honorati, M., and T. Mengistae. 2007. “Corruption, Business Environment and Small Business Fixed Investment Growth in India.” World Bank Policy Research Working Paper 4356, September.

Researchers

TAYE MENGISTAE is a senior economist in the Africa region. His research interests include the role of institutions in microeconomic decisions including occupational choice, business formation, business investment, and foreign market participation. Email: tmengistae@worldbank.org

MADDALENA HONORATI is a research analyst in the Development Research Group (Macroeconomics and Growth Team). Her research interests include firm productivity and the relationship with institutional quality, informality and ownership structure. Email: mhonorati@worldbank.org